Why Countries Trade: A Look at Benefits and Risks

Trade is an important part of the global economy, and it has grown significantly over the post-World War II era.

The significant expansion of global trade over time suggests that there are recognized benefits of trade, but there are also risks. The latter have come into more focus in recent years—for example, during the COVID-19 pandemic—as have terms like “decoupling,” “reshoring” and “friendshoring.”

I consulted Fernando Leibovici, an economic policy advisor in the St. Louis Fed’s Research Division, about the benefits and risks of trade as well as some potential ways for countries to mitigate those risks, which is where the terms mentioned above come in.

Benefits of International Trade

Leibovici explained a few benefits of trade.

Comparative advantage

The standard view of international trade is that it is beneficial because it allows countries to specialize based on what they’re relatively good at producing, Leibovici said. Given that there are differences in how well countries produce different items, trade between two countries can lead to gains for both if they each specialize and trade what they produce.

As an example, say that the U.S. is good at producing a certain food relative to other goods and that France is good at producing wine relative to other goods. In other words, the U.S. has a comparative advantage in producing that food and France has a comparative advantage in producing wine. Trading food and wine between the two countries can lead to both being better off. The idea of specializing and trading based on comparative advantage goes back to the 1800s, and it has been an important driver of growth and development for many countries, Leibovici said.

Access to other goods

Trade allows people in different countries to access goods they otherwise wouldn’t be able to, Leibovici said. For instance, the production of some agricultural goods may require a certain type of land or climate, which means that countries would have to trade to acquire those goods they can’t produce themselves.

Risk sharing

Another benefit of trade that Leibovici mentioned is that it helps countries share risk, especially local risk. To illustrate, if a country had a major natural disaster that disrupted production of certain goods, the country may be able to obtain those goods from trading partners. In contrast, a fully closed economy—that is, one that doesn’t trade with anyone else—would be limited to what it has on its own.

Leibovici added, however, that a global shock, like the COVID-19 pandemic, would affect the country’s trading partners as well, potentially leaving them unable to help provide goods.

Some Risks of International Trade

While trade can help with local risk management, depending on other countries to access certain goods has led to growing concerns about the potential for disruptions in recent years, particularly when it comes to “critical goods,” Leibovici said during our discussion.

He explained those concerns in the St. Louis Fed’s 2022 annual report.

“Some goods are critical to economic activity and welfare even though they account for a small portion of aggregate output and consumption,” he said in the report, noting that dependence on international trade for such critical goods is a potential source of vulnerability for the U.S. economy.

“Geopolitical risk (such as war), reliance on risky trade partners and shocks to trade institutions can severely disrupt the short- and medium-run access of the U.S. economy to critical imported goods,” he wrote. During our conversation, Leibovici also cited shipping disruptions as another risk that may limit a country’s access to goods from other countries.

A key example of a critical good is semiconductors, which are used in the production of computers, toys, appliances, cars and many other goods, as Leibovici noted in the 2022 annual report. The U.S. is a net importer (i.e., imports exceed exports) of semiconductors, with Taiwan being a top source for U.S. imports of these goods. Semiconductor shortages in recent years have had notable effects across the globe, he wrote.

Medical goods are another example; their critical nature became particularly clear during the pandemic. “Countries that relied heavily on imports of critical medical goods—such as personal protective equipment—found themselves at a distinct disadvantage when the pandemic created a sharp worldwide increase in the demand for these goods,” Leibovici and Ana Maria Santacreu, also an economic policy advisor, wrote in the St. Louis Fed’s 2020 annual report.

Possible Ways to Reduce Trade Risk

Even though trade is good in the long run, certain shocks can expose an economy to risks, especially if the imported goods are considered critical, Leibovici reiterated during our discussion. Some people suggest that increasing suppliers of these types of goods would be a way to lessen a country’s exposure to trade risks, he said.

He described some possible ways countries could go about diversifying trade. “Decoupling” refers generally to reducing trade with countries that could be potentially risky due to a variety of reasons, Leibovici explained. So, what might a country do if it has reduced its dependence on potentially risky countries for certain imports? Two possible options for accessing the goods Leibovici mentioned are: